New solutions to old problems

Feb 22, 2018

Finance Minister Malusi Gigaba delivered his Budget Speech 2018 to Parliament on Wednesday, February 21st. South Africans had high expectations of the event following the tone set by President Cyril Ramaphosa’s maiden State of the National Address (SONA) 2018, delivered less than a week earlier at the same venue.
The SONA reflected President Ramaphosa’s desire to turn around the South African economy, while Minister Gigaba’s speech was expected to provide the hard numbers to realise these plans.

This is according to PwC’s Lullu Krugel and Christie Viljoen, who unpack yesterday’s budget.

Key takeaways

* Upwardly revised economic growth projections of 1.5% and 1.8% in 2018 and 2019, respectively, as investor and business confidence improves

* Budget deficit to decline from 4.3% of GDP in 2017/18 to 3.6% of GDP in 2018/19, with commitment to narrow the fiscal deficit further over time

* Gross public debt to peak at 56.2% of GDP during 2022/23 after the medium-term budget (October 2017) failed to plan for a stabilisation

* Exposure to contingent liabilities increased in 2017/18, with government planning a holistic reform programme for state-owned enterprises (SOEs)

* Departmental budget cuts of R85.7bn over the next 3 years, with allocations to all layers of government

* Biggest reallocation in expenditure will be R57 billion over three years for fee-free higher education, with first year students benefitting from 2018

PwC’s interpretation of the Budget Speech of 2018 is that it should be enough to keep Moody’s Investors Service from making another cut in South Africa’s sovereign rating. Various rating agencies will likely welcome the improved economic growth projections, a narrowing fiscal deficit trajectory, and plans for a turnaround in public debt, which Minister Gigaba presented.

Improved outlook for economic growth

The National Treasury is forecasting an improved economic outlook for the country, and has revised higher its projections for economic growth. The government now sees the South African economy growing by an average of 1.65% during 2018-19 compared to an estimate of only 1.3% reported some five months ago in the Medium-Term Budget Policy Statement (MTBPS). Similarly, the South African Reserve Bank (SARB) revised upward its economic growth projections to 1.5% for 2018-19 in its January monetary policy statement. These upward adjustments are premised partly on a perceived improvement in business and investor confidence over the past few months.

Minister Gigaba is hoping that this growth performance will contribute towards the state’s plans for radical socio-economic transformation. Other measures include a planned R2.1 billion fund shared between several ministries and aimed at boosting small- and medium-sized enterprises (SMEs) during their start-up phase. This will add to some R1.4 billion in private sector commitments toward a business-led fund that will aim to support high-potential SMEs.

In order to boost economic growth over the medium- to long-term, the finance minister has approved six special economic zones (SEZs) in order to encourage investment in manufacturing and tradable services; sectors that encourage exports, job creation and economic growth, Industrialisation incentives worth R18.8 billion over the medium term will also help in realising President Ramaphosa’s desire to see the manufacturing sector lead the job creation agenda that he envisions over the next five years.

A narrowing deficit path returns

While drafting the medium-term plans that were released in October last year, the National Treasury was experiencing a challenging period both from an economic as well as political perspective. The outlook for both was uncertain towards the end of last year and the beginning of 2018, thereby constricting the ability of fiscal planners to plot a trajectory for the budget deficit.

The results of the MTBPS were disappointing: the deficit was planned to plateau instead of shrink. National Treasury appeared to be in a holding pattern until there was more certainty about the country’s political outlook.

Moving to the present, the Budget Speech of 2018 was delivered in a much more constructive political environment and an improved outlook for the economy. As a result, Minister Gigaba and his team were able to reintroduce into their plans a long-held commitment to narrow the fiscal deficit over the next three years. From a large shortfall of R204.3 billion in the 2017/18 financial year, the deficit is planned to narrow to R180.5 billion in the coming 2018/19 year.

This year’s budget deficit is expected to reach an equivalent of 4.3% of GDP — in line with the MTBPS statement. This will be followed by a notable decline to 3.6% of GDP in the 2018/19 and 2019/20 fiscal years. Both expenditure and revenue is expected to rise in these periods, in nominal terms and as percentage of GDP.

VAT and other tax increases to bolster revenues

In order to fund these deficit-narrowing aspirations, the National Treasury has to make plans both on the income and expenditure sides of its responsibilities. Regarding revenues, it was widely expected that some tax rate increases would be announced in Budget Speech 2018. Indeed, the value-added tax (VAT) rate was increased by one percentage point to 15%, with zero-ratings continuing on essential food items. The regressive nature of this tax type has led National Treasury to postpone increases in VAT until now, after keeping the VAT rate stable for the last 25 years.

Poorer households are more exposed to changes in the prices of consumption goods, like food. Low-income households will be compensated to a degree through above-average increases in social grants.

The government considered alternatives to a VAT increase, for example higher personal income and capital gains taxes, but assessed that these “would have greater negative consequences for growth and investment”. The VAT rate has not been changed since 1993 despite significant changes elsewhere in the tax basket. A higher corporate tax rate would also be counter to global trends of easing corporate tax rates. South Africa’s VAT rate will however still be below the global average of 15.7%, and will be at a similar level to the average of African countries at 14.8%.

Elsewhere, the National Treasury is increasing the ad valorem excise duty rate on luxury goods from 7% to 9%, while a higher estate duty tax rate of 25% will be levied on estates greater than R30 million. These two components will have an impact on middle to high income earning households. Two additional revenue-raising measures will impact a wider spectrum of South Africans: a 52c/litre increase in fuel levies and a 6%-10% increase in alcohol and tobacco excise duties. The normal inflation-related adjustments are also being made to personal income tax brackets, though with some drag at the bottom end to widen the coverage.

Minister Gigaba believes that these and other measures will result in government revenue rising by 10% in 2018/19 to R1.491 trillion. Some R36 billion will come from the above-mentioned tax increases, with R22.9 billion expected from the higher VAT rate. The health promotion levy — more commonly known as the sugar tax for being levied on sugar-sweetened beverages (SSBs) — will be implemented from April this year. The levy will amount to 2.1 cents per gram of sugar in every 100ml, with the first 4 grams per 100ml being exempt from the tax. PwC estimations suggest the tax burden is approximately 10% given current levels of sugar content in popular SSBs.

A tax on carbon emissions will also be effective from January 2019 while below-inflation increases in medical aid tax credits are also being implemented.

Large reallocation of expenditure to higher education

Government expenditure will increase by 7.3% in 2018/19 to R1.67 trillion. Apart from normal adjustments made to spending lines, the biggest reallocation in expenditure will be an additional R57 billion channelled to fee-free higher education over the medium term. From 2018, all first-year students at universities and Technical and Vocational Education Training (TVET) colleges from a household earning less than R350 000 per annum will be funded for the full cost of study. This will be rolled out in subsequent years until all academic years are covered.

Post-school funding will be the fastest growing expenditure item over the medium term alongside the cost of servicing the state’s debt obligations. Debt servicing costs will total R180 billion in 2018/19 and is expected to grow by an average of 9.4% per annum over the next three years. Healthcare spending will increase by an average of 7.8% per annum in coming years as the government allocates more money to the National Health Insurance (NHI). Some of this money will come from the amendment to medical aid tax credits. While Budget Review 2018 provided the usual information on healthcare spending, it gave very little in terms of new details about the NHI. Nuclear energy is absent from spending plans.

State-owned enterprises (SOEs) still a heavy burden

The SONA made an unequivocal commitment that government will intervene in turning around the deteriorating governance and finances of SOEs. Minister Gigaba underscored the progress to date, including key leadership appointments at South African Airways (SAA) and Eskom.

He added that SOEs are expected to fund their own operations, but admitted that government recognises that the current business models of some SOEs are unsustainable. He indicated that a holistic reform programme will work to develop and implement robust turnaround plans for these troubled entities, but did not really provide any details. Reforms could include the participation of private entities in some build projects, such port terminals.

The burden of SOEs on the fiscus is a key challenge for the government due to the large volume of contingent liabilities – commitments by the state to cover the costs of financing of SOEs if these entities are unable to repay debt. On a positive note, government guarantees declined from R476 billion in 2016/17 to R466 billion in 2017/18. However, guarantees to troubled SOEs like Eskom and SAA did not decline, while total exposure to guarantees, that is, borrowing by SOEs against the guarantees, increased by 3.4% in 2017/18 to R300 billion. Some SOEs struggled over the past year to sell bonds due to hesitance amongst investors, thereby forcing them to resort to guaranteed loans.

What will the rating agencies say?

The MTBPS provided no answers to concerns over rising public debt levels apart from indicating that a ministerial committee would be established to develop proposals on how to stabilise national debt over the medium term. Thankfully, the Budget Review of 2018 showed progress in this area, with National Treasury planning for gross public debt as percentage of GDP to peak at 56.2% during the 2022/2023 financial year. This debt ratio will also rise more slowly over the next few years compared to recent history. The turnaround in public debt is facilitated by departmental budget cuts of R85.7bn over the next 3 years, with allocations to all layers of government.

Minister Gigaba admitted that the income and expenditure measures needed to narrow the fiscal deficit and limit growth in public debt “will cause economic discomfort, but they are necessary to protect the integrity of the public finances”. Indeed, the decisions announced on February 21st are important steps towards improving the country’s fiscal dynamics and, in turn, the sovereign’s creditworthiness. Rating agencies will have to decide if the minister’s view that “we have made the tough calls and decisions” holds true.

These agencies are expected to welcome improved economic growth projections, a narrowing fiscal deficit trajectory, and plans for a turnaround in public debt. They would certainly have wanted more detail on the planned reform programme aimed at turning around SOEs. Nevertheless, their view of the required political will to make the necessary changes should also have improved over the past two months, and over the past week in particular.

Overall, PwC believes that this year’s Budget Speech should be enough to keep Moody’s Investors Service from making another cut in its rating of the South African sovereign, with an evaluation due over the next few weeks. This is very good news: another downgrade would result in South Africa being excluded from the Citi World Global Aggregate Bond Index (WGBI). Exiting the WGBI could result in more than R100-billion in foreign money exiting the domestic capital market.